A year like no other for most of us around the world will be remembered in the US and international financial markets for five major features:
The Great Disconnect Between Wall Street and Main Street: Apart from a few weeks culminating in the market lows of March 2020, stocks managed to shrug off what has been a drastic collapse in global economic activity with significant immediate and longer-term consequences. This incredible decoupling has shown no sign of slowing even as markets trade at historically elevated valuation levels. If anything, an exceptional disconnect has become larger. Stocks have set one record after another, while economies have had to deal with another wave of covid.
Explanations Chasing Price Action: Unless you are, as I am, a great believer in the overwhelming influence on markets of ample and predictable central bank liquidity, particularly from the US Fed and European Central Bank, it has been difficult to find a durable narrative to explain and predict this year’s exceptional prices. Indeed, rather than narratives leading market action, market action has led to consensus explanations that often proved inconsistent. There are several examples, including three conflicting political narratives that were embraced widely in mid-2020 by market participants to “explain" consistently rising stocks: High prospects for the re-election of President Donald Trump with a lower-tax, less-regulation agenda; a divided government that would keep it sidelined and allow business to flourish unhindered by interference; and a Democratic Party wave that would result in huge fiscal stimulus that would boost demand.
The Dual Liquidity Phenomenon: In 2020, investors experienced illiquidity in what are the biggest and traditionally the most liquid markets and liquidity in usually illiquid segments. Specifically, March will be remembered as the moment when even flows into US Treasury bonds were disrupted sharply. A few weeks later, the Fed’s intervention in markets, including surprise purchases of high-yield securities, injected liquidity far and wide, and induced “cross over" investors to venture well away from their normal habitat. By year-end, the deep belief in an everlasting “central bank put" meant that, of all risks facing investors, those associated with liquidity are back to being the most under-appreciated.
The Search for Risk Mitigation: The more central banks have succeeded in repressing market yields on “risk free" government bonds (and confronted investors with little to no income and adversely asymmetric price risk), the more investors have searched for new and more attractive ways to mitigate risk—so much so that a growing number of market commentators commented during 2020 on the prospective death of the traditional 60/40 stock-bond portfolio. Many investors, especially those facing negative yields on government bonds, have ventured to other areas of the fixed-income market in an attempt to offset the risks associated with their large equity positions. What began as purchases of short-maturity investment-grade bonds—on the correct premise that the Fed has put them under a protective umbrella with its own buying—has evolved to include debt with far higher default risk, such as high-yield and some emerging-market bonds. Others have adopted more of a basket approach, adding gold, Bitcoin and other cryptocurrencies to government bonds.
Lack of Emerging-Market Accidents: Emerging economies have found themselves in a perfect economic storm because of covid-related disruptions. Because of the global economic “sudden stop" and the geographically uneven recovery that has followed, many have seen export revenues collapse, tourism earnings disappear and inflows of foreign direct investment evaporate, with some even facing the prospects of outflows. Yet, with the exception of preexisting condition countries such as Argentina, Ecuador and Lebanon, the vast majority of emerging markets avoided debt defaults and big restructurings. Indeed, with liquidity returning quickly to financial markets, and with investors hunting for greater yields, a record level of EM bonds was issued at exceptionally low risk spreads and overall yields.
Combined, these five factors add up to a year that has given investors a great deal of what they could wish for—especially in terms of handsome returns with notably low volatility (leaving aside March). They are also factors that speak to the dominant market influence of central banks, which anchors an unhealthy co-dependent relationship that most investors are keen to continue, regardless of the declining benefits for longer-term economic and financial well-being, together with mounting collateral damage and the spread of unintended consequences.
Mohamed A. El-Erian is a Bloomberg Opinion columnist, president of Queens’ College, Cambridge and chief economic adviser at Allianz SE
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January 03, 2021 at 10:41PM
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